Tag: Euro

It's been a tough year for Europhiles, especially those, like me, who have always supported the single currency and thought Britain should have been part of it. Most of them have been very quiet, and no wonder. Whatever one says quickly has the feel of being out of touch and in denial. And now this week the Economist asks in a leading article Is this really the end? that has been tweeted over 1,200 times and picked up over 500 comments. In today's FT Wolfgang Munchau article is headlined: The Eurozone really has only days to avoid collapse(paywall). Is now the moment to finally let go, and admit that the whole ill-fated enterprise is doomed?

There is no doubting the seriousness of the current crisis. While most of the headlines have been about sovereign debt (especially Italy's) what is actually threatening collapse is the banking system. It seems to be imploding in a manner reminiscent of those awful days of 2007 and 2008. The Germans' strategy of managing the crisis on the basis of "just enough, just in time" seems to be heading for its inevitable denouement. Unless some of their Noes turn to Yeses soon there could be a terrible unravelling.

The most urgent issue is to allow the European Central Bank (ECB) to open the floodgates to support both banks and governments suffering a liquidity crisis. "Printing money" as this process is often referred to, seems the least bad way to buy time. Two other critical elements, both mentioned by Mr Munchau, are the development of "Eurobonds" - government borrowing subject to joint guarantee by the member states - and fiscal integration - a proper Euro level Finance Ministry with real powers to shape governments' fiscal policy in the zone. Most commentators seem to be convinced that some sort of steps in both these directions will be necessary to save the Euro.

I have a lingering scepticism about these last two. I thought that the original idea of allowing governments to default, and so allowing the bond markets to act as discipline, had merit. The problem was that the ECB and other leaders never really tried it before the crisis, allowing investors to think that all Euro government debt was secure.

Still the short term crisis is plainly soluble, and most people will bet that the Germans will give the ECB enough room to avert collapse. But that leaves the zone with a big medium term problem, and two long term ones. The medium term one is what to do about the southern members whose economies are struggling: Spain, Portugal and Greece especially, with Italy lurching in that direction. The stock answer, which is to enact is reforms such that their economies become more competitive, seems to involve such a degree of dislocation that we must ask if it is sustainable. This treatment is not dissimilar to that meted out by Mrs Thatcher to Britain in the 1980s (an uncompetitive currency was part of the policy mix here, deliberately or not), for which she is still widely loathed. And she was elected (though "democratically" is a stretch given Britain's electoral system). How will people react to unelected outsiders imposing such treatment? Better than Britons would, no doubt, since there is so little confidence in home grown politicians , but it's still asking a lot.

And that leads to one of the two long-term problems: the democratic deficit. A lot of sovereignty is about to be shifted to central institutions, and it won't be possible to give electors much say. The second long term issue is dealing with the root cause of the crisis in the first place, which is how to deal with imbalances of trade that develop within the Euro economy. Germany simply cannot have a constant trade surplus with the rest of the zone without this kind of mess occurring at regular intervals. But there is no sense that German politicians, still less their public, have the faintest grasp of this. For them the crisis is the fault of weak and profligate governments elsewhere.

So if the Euro survives the current crisis, there is every prospect of another one down the road, either political (one or more countries wanting to leave the Euro and/or the Union) or financial (say an outbreak of inflation).

My hope earlier in the crisis was that it was part of a learning curve for the Euro governments. As they experienced the crisis institutions would be changed and expectations made more realistic, such that zone could get back to something like its original vision. I am afraid that there is a lot more learning to do.

It is a commonplace amongst Anglo-Saxon policy makers that the Eurozone leaders need to use a "big bazooka" to solve the currency crisis that is engulfing the continent. David Cameron has been particularly conspicuous in using this expression. Is it all it is cracked up to be?

So what is a bazooka? Originally it was a tubular musical instrument made famous by the comedian Bob Burns in the 1930s (Mr Burns and instrument in second picture). It then became the colloquial name for an American tubular hand-held antitank weapon introduced in the Second World War (the illustration above is in fact of a more modern and shorter weapon). This was a revolutionary innovation, using recoilless technology and the so-called HEAT armour-penetration system - which allowed infantry to threaten tanks in a way not previously possible. The Germans quickly copied it with the bigger and better panzerschrek ("tank terror"). They also developed countermeasures, including thin armoured outer skirts to their tanks, which set off the HEAT system before it could inflict serious damage. In the 1960s the weapon became obsolete, replaced by more powerful technologies.

A "big bazooka" in the current context is used to mean the deployment by the state (central banks and/or governments) of overwhelming financial resources to bail out troubled banks and others in a financial crisis. The idea is to break a vicious cycle of declining confidence in banks and others, whereby lack of confidence becomes a self-fulfilling prophecy as creditors seek to move their money into safer places. The mere proposition of such resources can be enough to break the cycle, if credible, and prevent the resources ever having to be deployed. The Americans can proudly point out to the use of the technique to solve a series of financial crises, from the Savings & Loan crisis of the 1980s, to the LTCM collapse of the 1990s and the Lehman crisis of 2008. Such tactics are conspicuous by their absence in the Euro crisis, fiercely resisted by the German political class in striking unanimity.

There is an irony that the original bazooka was quite a small weapon - but I suppose it was big for one held by a single infantryman, and the German version conveys all the imagery the metaphor needs. A more telling parallel is that the bazooka, revolutionary when introduced, steadily became obsolete as the world got used to it. No doubt the Germans will point out that the American use of "big bazooka" tactics on repeated occasions shows that there is a flaw. The American financial system suffers a systemic crisis every 10 years or so. This is the first such crisis the Germans have endured since their currency was refounded after the war - and that is because the Germans aren't running the show.

The have a point. The financial markets are amazingly short-sighted - for example that idea that the US and UK are safe havens because their central banks can overcome any crisis by "printing money", or monetising debt, in the manner of Zimbabwe. But the long term logic always wins in the end. There seems to be a slowly dawning realisation amongst Anglo-Saxon commentators (for example last week's Martin Wolf column, as well as the Economist) that the German position in all this amounts to a strategy, "just enough, just in time", and not the absence of one - even if Mr Wolf grumpily calls it "too little, too late". The short-term costs of the German strategy are doubtless higher than the American way - but the longer term position is much less clear.

I do not regret paying my access fee to the FT website. This morning there are two excellent articles on the Euro crisis from the two regular Wednesday morning columnists: Martin Wolf and John Kay. It has helped clarify the way ahead for me.

Mr Kay comes in at high level to give an overview of the crisis. It is not comfortable reading for supporters of the Euro project like me, but, as usual for this author, pretty much spot on. The main problem is not that the currency area lacks appropriate institutions at the centre, but that local institutions in many member countries are not strong enough to cope with the pressures of being in the single currency.

The eurozone’s difficulties result not from the absence of strong central institutions but the absence of strong local institutions. A miscellany of domestic problems – rampant property speculation in Ireland and Spain, hopeless governance in Italy, lack of economic development in Portugal, Greece’s bloated public sector – have become problems for the EU as a whole. The solutions to these problems in every case can only be found locally.

So the answer will not come from strengthening the EU's central institutions. This goes back to the original design of the Euro: the whole idea was to put pressure on governments to reform themselves, by denying them the easy escape route of devaluation. Unfortunately the EU's politicians forgot this in the first decade of the Euro, so no real pressure was brought to bear, making the crisis infinitely worse once it hit.

This article does not say much about how to go forward from here, beyond suggesting that grandstanding at summits like today's may be part of the problem rather than the solution. Mr Wolf's looks at one aspect of how to manage the crisis itself. This in turn in is based on a paper by Paul de Grauwe of Leuven university, who literally wrote the textbook on the Euro (I know, since I read it as part of my degree course).

Professor de Grauwe points out an interesting fact: the bond markets are much harder on the Euro zone fringe economies of Italy and Spain than they are on the UK, even though the underlying positions of the countries is not all that different. The difference is that the UK markets are stabilised by having the Bank of England as a lender of last resort which is able to deal with liquidity crises (i.e. an inability to raise cash for temporary reasons rather than underlying insolvency). The European Central Bank does not do this, or not enough, for the Eurozone economies. Mr Wolf, who structures his article as an open letter to the new ECB president Mario Draghi, argues passionately that it should. This would stop the contagion spreading from the insolvent economies of Greece and maybe Ireland to solvent but challenged economies like Italy, Spain and indeed France.

This must be right. The Germans, who are the main sceptics, must be persuaded - and convinced that such interventions would only apply to liquidity crises and not solvency problems, and that the ECB has the integrity and independence to tell the difference, in the way that politicians never do.

Giving the ECB a wider and stronger remit will be a big help. This should extend to supervision of the European financial system (preferably for the whole EU and not just the Eurozone). This will help deal with one of the biggest problems for modern central banking - that of coping with spillover effects, as described in this thought-provoking paper from Claudio Bono of the BIS (warning: contains mild economic jargon, such as "partial-equilibrium").

So a reconfigured ECB will help the Euro through the crisis and prevent self-fulfilling prophesies of doom in financial markets having to be solved in grandstand summits. That still leaves the longer term problem of how the less competitive Southern European economies can have a long term future in the zone. But then again, I think they would have just as challenging a future outside the zone - even if it were possible to devise an orderly exit mechanism for them.

I caught a bit of last night's Radio 4 Analysis programme driving home from a meeting, on Euroscepticism in Britain. One speaker (I didn't catch who) suggested that the case for Britain being in the EU was mainly economic - that we could put up with a bit of lost sovereignty because we were being hitched to an economic powerhouse that would do our economy good. This he said, was now clearly nonsense. In evidence he said that the EU used to be 26% on the world economy and now it is 18% (I may have misremembered the numbers). "We are being chained to a corpse." I was apoplectic. But it is typical of the drivel that is being spread across our media. It's worrying that so few people bother to argue back.

Let's clear the decks with some points of general agreement. The Euro is in crisis, and this crisis could lead to an economic disaster. This in some measure results from severe mismanagement of the currency by the EU's leaders, aided by the European Central Bank (ECB). The stock of European institutions is low in public eyes, not just in Britain, but across most of the continent. This has something to do with a democratic deficit - with the institutions wielding power with little apparent democratic consent.

But it is possible to accept all this, and to think that the EU, and even the Euro, is fundamentally a good idea, and that Britain would be mad to consider leaving it. The country may even be forced to join the Euro - though that event is surely a long way off.

Let me try to help the feeble defenders of British membership by elaborating four critical fallacies behind the Eurosceptics' arguments, and fifth that is a bit more arguable.

First fallacy: there is such a thing as "just" a free trade area. It often said the the country joined something that was just a free trade area, but this has morphed into something else. But free trade across borders is a complicated business - and not just a matter of border controls and tariffs. Its implications quickly reach into vast swathes of ordinary life. Most of the US Federal government's powers rest on its right to regulate interstate trade. And the unhappy experience of the North American Free Trade Area (NAFTA) shows how politics gradually undermines transnational free trade projects that do not involve a significant pooling of sovereignty.

Fallacy no 2. Britain is being ripped off by the rest of Europe because we have a trade deficit with them. This leads to the idea that outside Europe we would get a sweetheart deal (like Norway of Switzerland, or at least in popular myth) because they need us more than we need them. But the British trade deficit arises from the chronic mismanagement of the British economy, which led to a prolonged period (since the late 1990s) where the Pound was too high for many of our export businesses to be competitive. This uncompetitive exchange rate has now been reversed, and so our trade balance with the EU will correct. And as for bargaining power, there is a fatal flaw to this line of reasoning: the relative size of the UK against the rest of the EU. EU trade is a major part of our economy; UK trade is not a major part of the EU economy.

Fallacy no. 3. Being outside the EU means that we don't have to comply with EU regulations. This is largely true of the labour market, it has to be said. But far from true of product markets - since we need to sell our products in the EU. Also, if foreign manufacturers are forced to comply with separate British product standards before they can export here, they will either charge us extra or not bother. If you are in any doubt about this ask a Norwegian or Swiss about how much better life is without the burden of EU regulations. You will get a lecture about how they have to comply anyway, without any input into how they are made. This is of particular relevance to one of the areas where Britain has a competitive edge: financial services. Our representatives in Europe are forever batting back ideas for new rules that would disadvantage the City; I wonder what would happen if they weren't there any more?

Fallacy no 4. We would save money by leaving the EU, because we are a net contributor to the EU budget. This is an illusion. We may pay less in net contributions, but we would pay more in tariffs And if we charge more tariffs in return? Any economist will tell you that this is a road to nowhere. Our net contribution is a small price to pay for access, and, besides, some of it helps to develop new markets in the Union's less developed countries.

Fallacy no 5. Britain would have been worse off by joining the Euro at the start. This contention is unprovable, as is the opposite: that we would have been better off in it. The Euro, of course was badly managed. But so was the Pound. While the Euro was going on, the pound shot up in value, destroying many of our exporters and creating a big trade deficit. Borrowing ran amok, as did, to a lesser degree, government expenditure. When it all blew up, it left the British economy in a terrible state, one that it will take many years to recover from. Won't the devaluation of the pound help our recovery? Yes, but it should never have got that high in the first place. What would have happened if we were inside the Euro? Almost certainly no better - except that our problems would have been more transparent, so we might have started to fix them a more quickly. My point: an ugly mess either way. Look at our Eurozone colleagues and the British economic performance does not look stellar. A floating currency is no free lunch.

Of course there is a lot wrong with Europe and the Eurozone. That does not mean that this country is better off outside. The best case for a referendum in this country is that it would force supporters of the Union to make the case more forcefully, and expose the fraud behind the anti-EU case. But on their performance to date, who can be confident of that?

My favourite contemporary economist is UCL's Professor Wendy Carlin. She was my tutor at UCL, and led my second year macroeconomics course, and a third year course on European institutions. Her patient, dispassionate analysis is worth so much more than all that shoot-from-the-hip banging on by celebrity economists, Nobel Laureates and all. It was her analysis, well before the current crisis broke, that demonstrated to me that the last government's economic "miracle" was unsustainable (the combination of an appreciating real exchange rate and a trade deficit being the giveaways). She also helped me understand the Eurozone, and pointed out the trouble ahead, again well before it happened, arising from diverging real exchange rates within the currency bloc - in other words Germany was becoming more competitive while Italy, Spain and others were becoming less so.

So I was delighted to read her summary of the Eurozone crisis - 10 questions about the Eurozone crisis and whether it can be solved. The is a wonderfully clear summary of the whole situation, written in early September. Her central point is that the zone's banking system is at the heart of the crisis, and tackling the banks will the heart of any solution. European politicians have been trying to avoid this, no doubt because it shows that Northern European countries have played an important role in creating the crisis. However, not least thanks to the new IMF chief Christine Lagarde, this is changing.

Of course Professor Carlin cannot point to an easy escape. She points to two alternatives paths, other than the breakup of the zone:

Scenario #1 – a more decisive approach based on current policy (bailouts)Policy-makers need

the existing bailout schemes to be successful and to be seen to be working in the next year

to keep Italy out of the bailout regime

to develop a replacement for the high moral hazard regime for banks and for governments but to do this in a way that does not undermine the bailout regime in the meantime.

European politicians are attempting the first path, but the problem is contained in Professor Carlin's third bullet: devising a financial scheme that avoids moral hazard by banks and sovereign states - this reckless behaviour in the belief that it will be underwritten by everybody else. The favoured answer of many is a "Eurobond" - i.e. government borrowing underwritten collectively, combined with a toothier version of the failed Stability & Growth pact. But this decisive step towards a more federal Europe runs well beyond any democratic mandate. The German Chancellor, Angela Merkel, is rightly suspicious.

Which leaves the second scenario, which is favoured by American commentators, based on their experiences of Latin American debt crises. This is surely much more convincing, and I hope that the IMF will use its influence to push down this path. Bank regulation clearly needs to change, but beyond that it doesn't need a more federal Europe. We can use bond spreads to act as a break on government profligacy - which is how the Eurozone should have been run from the start.

A final point worth making from Professor Carlin's analysis is that dropping out of the Eurozone wouldn't really help Greece or any other country that much. They would still have to run a government surplus, and so still have to go through a very painful reform programme sucking demand out of their economies. Of course the hope is that a rapid devaluation would kick start exports - but it does not stop the need for painful supply-side reforms if these countries are to recover anything like their former standards of living.

It is a commonplace for Britain's politicos to sadly shake their heads and complain that the Euro crisis demonstrates a woeful lack of political leadership. Regardless of the fairness of this charge in respect of Angela Merkel, say, it clearly has resonance for Britain's own leaders. There seem to be two camps: ravingly impractical Eurosceptics, and sheer paralysis from everybody else. The mood amongst Europhiles (as I witnessed at fringe meeting at the Lib Dem conference) is akin to deep depression. It is time for this to change.

To be fair some key players have been showing something less than paralysis - George Osborne and Nick Clegg have both been conspicuous in raising the seriousness of the situation with their international colleagues - but their pronouncements are hardly more helpful than anybody else's. They aren't bringing anything to the party and they aren't trying bring our own public alongside.

The first point is that the Euro crisis has serious implications for Britain, much though most people seem to think it is happening to somebody else. This is for two main reasons. First is that this country would be caught up in any financial disaster. Our oversized banks are deep in the mess; Euro zone countries are vital trading partners for a country very dependent on trade - especially given that international financial services are so important to us. Our fragile attempts at recovery risk being completely blown off course. Forget Plan B if this lot breaks.

The second reason it matters to Britain is that resolution of the crisis could take the European Union in a direction that is against our interests. Britain leads the single market wing of the union: the chief Euro zone countries are more protectionist in their instincts. We risk being shut out of the design of critical architecture - much as the Common Agriculture Policy was put together in our absence.

How to proceed? We need to tackle the dark spectre head on: the best resolution of the crisis involves changes to the European treaties. To change the treaties will require a referendum here (let's not weasel out of it this time). If we face up to that challenge now, it will show real courage, and help get things moving.

But, of course, we would need to see something in return. Changes to the treaties that would further our interests. These need to be to promote the single market, to protect London (and Edinburgh) as centres for financial infrastructure, and to reduce unsightly bureaucracy and/or operating costs of the Union (the siting of the European Parliamnet at Strasbourg needs to go on the table, at least). Given our understanding of finance, we might well have useful things to say on the Eurozone architecture too - even though we clearly can't be part of it.

To do this our leaders (the Prime Minister and the Deputy Prime Minister in the lead) need to build two sets of alliances. The first is within the British body politic, so that the referendum can be won. This needs to cover Tory pragmatists (David Cameron, George Osborne and William Hague), the Labour leadership and, preferably, the SNP. The Lib Dems have an important role in making this hold together since, by and large, they understand the Union the best. Mr Clegg's experience of deal-making in the European parliament counts for a lot. The next set of alliances is within the Union itself, to create a Single Market bloc. The obvious candidates are the Nordic countries, Ireland and the Netherlands, together with many of the newer members in central and eastern Europe.

This will be very difficult. That's the point, almost. The reward is a stabler EU, constructed more to our taste, even if we must concede some powers to an inner core of Euro area countries. Everybody wins. And by taking on the wilder Eurosceptic fringe, including their newspaper backers, it will cheer all right-thinking people up. It's time we stopped being paralysed by fear and came out fighting.

It's a grim time for supporters of the Euro project like me. Hardly a day goes by without hearing some highly patronizing person going on about how a country fixing its exchange rate is a terrible idea because it can't then devalue when it hits trouble, and how the austerity policies in the Euro zone are doomed to fail. One irony is that many of these people are from the the political right; the sort of people who think that the Thatcher revolution of the 1980s was not just a good thing, but a turning point for the British economy. In fact the Euro advocates are proposing very similar medicine for southern Europe.

The UK economy inherited by Mrs Thatcher in 1979 was a mess. Both unemployment and inflation were persistent, and the country was referred to to as "the sick man of Europe". Mrs Thatcher's solution was to focus on the long or medium term drivers of success, with utter contempt for short-term palliatives. She progressively liberalised the economy, and in particular the labour market, then dominated by trade union power, and taxation, which had reached punitive levels on the rich (and not so rich, come to that). In macroeconomic policy she believed in squeezing down inflation through tough monetary and fiscal policies. Interest rates soared. Amongst other things, the pound rapidly appreciated. This was all part of the medicine.

The results were indeed dramatic. Unemployment got much worse, with devastation sweeping through great swathes of industry - all of which makes our current troubles look like small beer, even though, according to GDP statistics, we are supposed to be in a worse mess now. But in due course the economy prospered and reached undreamed of heights - though some parts of the country never recovered.

Back to the Euro zone. The underlying problem with all of the currently struggling economies, except Ireland maybe, is not entirely dissimilar to that faced by Britain in 1979. A host of product market, labour market and tax inefficiencies have conspired to make their economies relatively uncompetitive. The political will to tackle these problems has been lacking. Before the Euro they could simply let their currencies slide to offset this lack of competitiveness. But all this did was to ensure that the living standards of citizens stayed below their potential. And it was unsustainable in the long term; eventually you get to stagflation and even hyperinflation - a fate which Portugal in particular was reaching before the Euro project offered rescue. Once in the Euro devaluation is not an option, and so politicians have to focus on medium and long term reforms. This is what they are now doing, some with more enthusiasm (say Portugal) than others (say Italy).

Mrs Thatcher, of course, would never approve of a country joining the Euro - she treasured national sovereignty too much - but she would have approved of many of its consequences. Mrs Thatcher did not believe in devaluation.

But this is hardly an advertisement for the Euro for many. A lot of people still think that the Thatcher years were a period of gratuitous violence with adverse consequences that we are still suffering. It was she that was responsible for the trashing of so much British manufacturing, with the appreciating pound very much part of this. And the work she started was capably continued by Messrs Brown and Blair, since a high pound, together with aggressive exporting practices from China and India, had a similar effect in the 2000s - albeit compensated by unsustainable jobs in finance and building.

And there is no avoiding that the southern European economies need to go through a process of harsh economic reform, or else suffer a slow slide into poverty. Euro advocates had always foreseen this; what they had not foreseen was that reduced government borrowing costs once in the Euro would allow these countries to put off the evil day, only to make it infinitely worse when it arrived.

While the British news media and politicos alike obsess with the unfolding of the News of the World hacking scandal, Europe's financial crisis enters a dangerous stage. In fact this crisis seems to unfolding just as quickly, and with much more important potential consequences. Was I being too sanguine last Friday, when I blogged that it was a learning curve rather than a fundamental problem? Well, probably.

I had hardly posted it than a flood of dire articles about the crisis came out. One of the best is by eminent US economist Larry Summers in this morning's FT(£); alongside it an equally gloomy article from FT regular Wolfgang Munchau (£). Mr Summers points to the critical issue of confidence that could be destroyed in a default, drawing a parallel with Lehman in 2008. He then offers quite a plausible way out. But the problem, as Mr Munchau points out, is:

I often hear that Ms Merkel in particular has moved a long way from her original position 18 months ago, when she ruled out any money for Greece. This is true. But the crisis now moves at a rate that exceeds her political speed limit.

There's clearly a problem. One issue is the expectation that European leaders will muddle through, as they always have. This, unfortunately, is a self-destroying prophesy. Because Europe's leaders expect everything to come right in the end, they don't have the incentive to make it actually happen. Actually Europe's greatest achievements have required some strong leadership, with Helmut Kohl, Germany's Chancellor in the 1990s standing out. Mr Kohl achieved German unification on his own terms, pushed through monetary union and the massive eastward expansion of NATO and the EU right into the former Soviet Empire. Mrs Merkel does not fill his shoes.

Still, there are plenty of bright ideas for ways out, without the Eurozone collapsing, Mr Summers's among them. They will all require Mrs Merkel to shift her current stance. Things could get worse before they get better. At any rate it looks more soluble than the US budgetary stand-off.

Coverage of the crisis in the Eurozone is astonishingly poor. Commentators scarcely try to analyse the situation properly; instead they revert to one of two unsatisfactory critiques. First, the Eurosceptic one, is that the Eurozone was always an unworkable idea and the best thing to do is abandon the whole thing. The alternative, the Europhile critique, is that a currency union without political integration was a major mistake, and the best thing to do is move further towards the political integration of the union.

These positions are both unhelpful. The Eurosceptics fail to see the benefits of the currency union, the awful logistics involved in unpicking it, or the unsatisfactory nature of floating currencies for most countries. The Europhiles want to drag European peoples down a road they do not want to go. There is a third way: that Eurozone governments change their countries' economic arrangements so that they can live within the currency zone, more or less as it is currently configured. This crisis is a learning experience.

The more far-sighted of the Eurozone's designers did not want full political integration. It was never to be a currency zone like the USA, with a federal government able to make massive fiscal transfers across the union to help balance out asymmetric crises. Instead the single currency, alongside the single market, was meant to act as a discipline on national governments. This would address the widespread failure of floating currencies, which allowed governments to buy time through currency depreciation rather than addressing economic inefficiency. This was a process leading inexorably to hyperinflation and economic collapse - which was very clearly beckoning for Portugal in particular before the Euro project was taken on board.

Discipline was required in two particular areas: government finances and labour markets. In the former case discipline is to be provided by the threat of default; in the zone it was impossible to evade default by debauching the currency. The consquences of a sovereign default are very severe, and European leaders sought to prevent it through the muddled Growth & Stability Pact, which sought to restrict deficits and levels of government debt. For labour markets the discipline was that without flexible labour markets, economies would become uncompetitive, creating unemployment.

But things went badly wrong almost immediately. Bond markets did not seem to believe the default story, as spreads between the more creditworthy governments (like Germany) and the less so (Italy and Greece) were impossibly narrow. Governments in the shakier countries (especially Italy, Portugal and Greece) found it much too easy to borrow cheaply and used this as an excuse for not proceeding with reform.

Labour markets were largely untouched by reform, as were other economic inflexibilities. This caused major problems in Spain, Portugal, Italy and Greece whose economies became increasingly uncompetitive. Only one country (apart from Ireland perhaps) really grasped the implications of living inside the Euro, and that was Germany. After unification the German economy lost competitiveness and unemployment became a real problem. But through its system of corporate deal-making between employers and unions, pay was restrained and other reforms instituted. Competitiveness was duly restored, as was employment. Unfortunately that made things worse for the laggards.

While the Eurozone had proved a failure in these two areas it proved a bit too successful in another: capital flows. There was a lot of reckless lending, with quasi-public banks in Germany in prominence. Capital flowed freely to countries, like Spain and Ireland, that didn't really deserve it, allowing problems to be hidden in a property bubble. And then Pop! The Eurozone has lurched from one crisis to the next.

But the basic idea remains intact. Markets now fully appreciate the risks of default and are pricing debt accordingly. This is applying pressure on governments like Italy's that the Growth & Stability Pact simply could not. And the pressure to make market reforms is likewise proving unbearable. It's been a horrible experience for many, but this is not a structural failure: it's a learning curve.

So what next? The Greek government must default, and default properly (i.e. the principal must be cut rather than repayment simply deferred). Maybe it will be forced out of the Euro. If so, it will be a terrible example. Some eurosceptics make it all sound rather easy ("decouple, default, devalue"), but it involves the utter collapse of the Greek economy with private savings being wiped out. The hope would be that it would be easier to rebuild from the ashes than interminable limping along inside the zone. Portugal and Ireland (whose crime was not to manage its banking system properly) may also go through some form of de-facto default. But they will stay in the zone. Portugal must go through a painful period of reforms, but at least for them this path is clearly better than being outside the Euro.

Meanwhile the Euro governments need to keep "kicking the can down the road". This is not as short-sighted as it sounds, since with each kick the various parties invovled understand the situation better and what needs to be done. The default word is now openly talked of. German bluster over not bailing out the profligate is gradually having to come to terms with the role German banks played in the disaster. There is learning for the Germans too. Bold decisive action can be disastrous - it didn't help the Irish. This way things are properly thought through.

Reforms? Fiscal reforms are unnecessary. But the banking system does need serious attention. The regulatory system is badly coordinated. There are too many cosy quasi-public banks who have been allowed to make silly investments. Banks remain largely national affairs, with only a limited number of transnationals. There is strong case for a centralised banking regulator. And cross-border banking mergers need to be encouraged.

But the Eurozone is not dead; and neither are we on the verge of a more centralised European government.